Download ratio - ENTR-203

Analysis of Financial Statements
Learning Objectives
Understand the purpose of financial statement
analysis.
 Perform a vertical analysis of a company’s
financial statements by:

 Comparing those accounts on the income statement
as a percentage of net sales and comparing those
accounts on the balance sheet as a percentage of
total assets for a period of two or more accounting
cycles.
 Determining those areas within the company that
require additional monitoring and control.
Learning Objectives (continued)
 Perform a horizontal analysis of a company’s
financial statements by:
○ Comparing the percentage change of components on
a company’s income statement and balance sheet for
a period of two or more years.
○ Determining those areas within the company that
require additional monitoring and control.
 Perform ratio analysis of a company and compare
those ratios to other companies within the same
industry using industry averages.
Learning Objectives (continued)
 Analyze the relationships that exist between the
several categories of ratios in determining the
health of a business.
 Distinguish between liquidity, activity, leverage,
profitability, and market ratios.
 Know how to obtain financial statements and
financial information from various sources.
Three Methods of Analyzing
Financial Statements
Vertical analysis
 Horizontal analysis
 Ratio analysis

Vertical Analysis

Vertical analysis is the process of using a single
variable on a financial statement as a constant
and determining how all of the other variables
relate as a percentage of the single variable.
Vertical Analysis of an Income
Statement
The vertical analysis of the income statement is
used to determine, specifically, how much of a
company’s net sales consumed by each individual
entry on the income statement.
 Constant is net sales.

The formula is:
Percentage of Net Sales 
Income Statement Item in $
100
Net Sales in $
Horizontal Analysis

Horizontal analysis is a determination of the
percentage increase or decrease in an account from a
base time period to successive time periods.
The basic formula is:
Percentage Change 

New time period amount - Old time period amount
100
Old time period amount
Table 4-1 Sample Income Statement Data
Markadel Retail Store
Income Statement Data
From January 1 through December 31, 2007 and 2008
Account
Year 2005
Gross sales
$ 300,580
Less returns
5,124
Net sales
295,456
Cost of goods sold
101,250
Gross profit
194,206
Operating expenses
Administration
74,983
Advertising
35,214
Overhead
27,120
Operating income
56,889
Interest
7,000
Earnings before taxes
49,889
Taxes
7,483
Net profit
$
42,406
Year 2006
$ 315,487
9,253
306,234
120,002
186,232
Vertical
Analysis
2005 (%)
101.73
1.73
100.00
34.27
65.73
Horizontal
Analysis 20052006 (%)
4.96
80.58
3.65
18.52
(4.11)
76,450
37,250
28,300
44,232
6,250
37,982
5,697
$ 32,285
25.38
11.92
9.18
19.25
2.37
16.89
2.53
14.35
1.96
5.78
4.35
(22.25)
(10.71)
(23.87)
(23.87)
(23.87)
Vertical Analysis of a Balance
Sheet

Vertical analysis of the balance sheet is always carried
out by using total assets as a constant, or 100 percent,
and dividing every figure on the balance sheet by
total assets.
The formula is:
Balance Sheet Item in $
Percentage of Total Assets 
100
Total Assets in $
Table 4-2 Sample Balance Sheet Data
Markadel Retail Store
Balance Sheet Data
As of December 31, 2007 and 2008
Category
Current assets
Cash
Notes receivable
Accounts receivable
Inventory
Total current assets
Fixed assets
Land
Buildings
Accumulated depreciation
Equipment
Accumulated depreciation
Total fixed assets
Total assets
Current liabilities
Accounts payable
Notes payable
Total current liabilities
Long-term debt
Mortgage payable
Bank loan payable
Total long-term debt
Total liabilities
Owner’s equity
Total liabilities and owner’s equity
Year 2007
Year 2008
$
$
$
$
10,210
5,280
15,320
35,020
65,830
25,000
135,000
(47,000)
58,250
(23,150)
148,100
213,930
8,175
8,102
18,025
50,515
84,817
25,000
135,000
(50,000)
58,250
(28,150)
140,100
$ 224,917
Vertical
Analysis
2007 (%)
Horizontal
Analysis
2007-2008 (%)
4.77
2.47
7.16
16.37
30.77
(19.93)
53.45
17.66
44.25
28.84
11.69
63.10
21.97
27.23
10.82
69.23
100.00
0.00
0.00
6.38
0.00
21.60
(5.40)
5.14
34,250
25,000
59,250
40,003
33,035
73,038
16.01
11.69
27.70
16.80
32.14
23.27
65,000
10,000
75,000
134,250
79,680
213,930
63,000
15,000
78,000
151,038
73,879
$ 224,917
30.38
4.67
35.06
62.75
37.25
100.00
(3.08)
50.00
4.00
12.51
(7.28)
5.14
Ratio Analysis
Ratio analysis is used to determine the
health of a business, especially as that
business compares to other firms in the same
industry or similar industries.
 A ratio is nothing more than a relationship
between two variables, expressed as a
fraction.

Types of Business Ratios
Liquidity ratios determine how much of a
firm’s current assets are available to meet
short-term creditors’ claims.
 Activity ratios indicate how efficiently a
business is using its assets.
 Leverage (debt) ratios indicate what
percentage of the business assets is financed
with creditors’ dollars.

Types of Business Ratios
(continued)
Profitability ratios are used by potential
investors and creditors to determine how much
of an investment will be returned from either
earnings on revenues or appreciation of assets.
 Market ratios are used to compare firms
within the same industry. They are primarily
used by investors to determine if they should
invest capital in the company in exchange for
ownership.

Liquidity Ratios

Current Ratio: The current ratio is calculated by
dividing total current assets by total current liabilities.
The current ratio is given by the following:
Current Assets
Current Ratio 
Current liabilitie s
Liquidity Ratios (continued)

Quick, or Acid Test, Ratio: This ratio does not count
the sale of the company’s inventory or prepaids. It
measures the ability of the firm to meet its short-term
obligations without liquidating its inventory.
The acid test ratio is given by the following:
Current assets - inventory - prepaids
Quick Ratio 
Current liabilitie s
Activity Ratios

Inventory turnover ratio (or, simply, inventory
turnover) indicates how efficiently a firm is moving
its inventory. It basically states how many times per
year the firm moves it average inventory.
Inventory turnover is given as follows:
COGS
Inventory turnover 
Average Inventory at Cost
where
Average inventory 
Beginning inventory  Ending inventory
2
Activity Ratios (continued)

Accounts receivable turnover ratio allows
us to determine how fast our company is
turning its credit sales into cash.
Accounts receivable turnover is given by the following:
Credit sales
Accounts receivable turnover 
Average accounts receivable
Activity Ratios (continued)

Average collection period is the average number
of days that it takes the firm to collect its
accounts receivable.
Average collection period is given by the following:
Days per year
Average collection period 
Accounts receivable turnover
Net Sales
DSO 
 365
Accounts receivable turnover
Activity Ratios (continued)

Fixed asset turnover ratio indicates how
efficiently fixed assets are being used to generate
revenue for a firm.
Fixed asset turnover is given by the following:
Net sales
Fixed asset turnover 
Average fixed assets
Activity Ratios (continued)

Total asset turnover ratio indicates how efficiently our firm
uses its total assets to generate revenue for the firm.
 Total asset turnover is given by the following:
Net sales
Total asset turnover 
Average total assets
Leverage Ratios

Debt-to-equity ratio indicates what percentage of the owner’s equity is debt.
Debt-to-equity is given by the following:
Total liabilities
Debt - to - equity ratio 
Owner' s equity
Leverage Ratios (continued)

Debt-to-total-assets ratio indicates what percentage
of a business’s assets is owned by creditors.
 Debt-to-total-assets is given by the following:
Total liabilitie s
Debt - to - total - asset ratio 
Total assets
Leverage Ratios (continued)

Times-interest-earned ratio shows the
relationship between operating income and the
amount of interest in dollars the company has to
pay to its creditors on an annual basis.
 Times-interest-earned is given by the following:
Operating income
Times - interest - earned ratio 
Interest
Profitability Ratios

Gross profit margin ratio is used to determine how
much gross profit is generated by each dollar in net
sales.
 Gross profit margin is given by the following:
Gross profit
Gross profit margin ratio 
Net sales
Profitability Ratios (continued)

Operating profit margin ratio is used to determine
how much each dollar of sales generates in operating
income.
 Operating profit margin is given by the following:
Operating income
Operating profit margin ratio 
Net sales
Profitability Ratios (continued)

Net profit margin ratio tells us how much a firm
earned on each dollar in sales after paying all
obligations including interest and taxes.
 Net profit margin is given by the following:
Net profit
Net profit margin ratio 
Net sales
Profitability Ratios (continued)

Operating return on assets ratio is also referred to
as operating return on investment and allows us to
determine how much we are actually earning on each
dollar in assets prior to paying interest and taxes.
 Operating return on assets is given by the following:
Operating income
Operating return on assets 
Average total assets
Profitability Ratios (continued)

Net return on assets (ROA) ratio is also referred to as net
return on investment and tells us how much a firm earns on
each dollar in assets after paying both interest and taxes.
 Net return on assets is given by the following:
Net profit
Net return on assets ratio 
Average total assets
Profitability Ratios (continued)

Return on equity (ROE) ratio tells the stockholder, or
individual owner, what each dollar of his or her
investment is generating in net income.
 Return on equity (ROE) is given by the following:
Return on equity ratio 
Net Profit
Average owner's equity
or
Net Profit
Return on equity ratio 
Average total assets - Average total liabilities
Market Ratios

Earnings per share ratio is nothing more than the net
profit or net income of the firm, less preferred
dividends (if the company has preferred stock), divided
by the number of shares of common stock outstanding
(issued).
 Earnings per share is given by the following:
Earnings per share ratio 
Net income - Preferred dividends
Weighted average number of common shares outstanding
Market Ratios (continued)

Price earnings ratio is a magnification of earnings
per share in terms of market price of stock.
 Price earnings ratio is given by the following:
Market price of stock
Price earnings ratio 
Earnings per share
Price Earnings to Growth
ratio(PEG ratio)

The price earnings to growth ratio (PEG ratio)
compares the company’s price earnings ratio to its
expected earnings per share (EPS) growth rate
over the next several years.
 The PEG ratio is given by the following formula:
Price earnings ratio
PEG ratio=
Annual expected growth rate in %
Market Ratios (continued)
 Operating cash
flow per-share ratio
compares the operating cash flow on the
statement of cash flows to the number of
shares of common stock outstanding.
 Operating cash flow is given by the following:
Operating cash flow per share 
Operating cash flow
Average common shares of stock outstanding
Free Cash Flow
 Free
cash flow gives businesses the
opportunity to set aside moneys from
operating activities and use them to
generate growth.
 The formula is:
Free cash flow  Cash flow from operations - capital expenditur es
Free cash flow per share 
Free cash flow
Average common shares outstandin g